Friday, February 12, 2010

What I Learned Writing a Book, Part IV: Of Colonoscopies, Cash and Cutouts

The question Buffett’s been asked is simple: ‘What’s the difference between Berkshire using undervalued stock to buy Burlington Northern, and Kraft using undervalued stock to buy Cadbury?’

It’s also quite good: Buffett has been beefing to anybody who’ll listen—and CNBC pretty much listens whenever he’s awake—about the price Kraft CEO Irene Rosenfeld is paying for Cadbury PLC, the iconic British chocolate company, and the fact that much of it will be in shares of Kraft.

He’s beefing about it because Berkshire Hathaway happens to be the single largest holder of Kraft stock.

But what really gets Buffett is that Rosenfeld did an end-around the “Oracle”—imagine that!—by cutting back on the stock portion of the deal to less than 20% of shares outstanding precisely so that Buffett wouldn’t have a chance to vote against the deal, as he promised to in a highly public, early January, press release.

(Charlie Munger, seen here looking over Buffett’s shoulder, no doubt feels equally slighted.)

For the record, Rosenfeld’s Kraft is paying roughly $21 billion all-in for Cadbury. This amounts to 24-times Cadbury’s trailing earnings, 14.3-times Cadbury’s trailing cash operating income (what analysts call ‘EBITDA’), and 3.8-times Cadbury’s book value.

(Yes, I know, most deals are priced on forward-looking sales and earnings…but investment bankers and chief financial officers can, and will, come up with whatever they need as far as futures go to justify their salaries and their bonuses. Garbage in, garbage out, as Buffett himself would say.)

For all that money, Kraft is getting a business that by my Bloomberg generates 45-50% gross margins, 12% operating margins, and throws off only enough cash from operations to cover capital expenditures. For a branded consumer business, this lack of “free cash flow” is hard to fathom, and sure to change under Kraft.

Some—including Kraft and its advisors—could argue the company is picking up an irreplaceable consumer franchise at a multiple of sales and operating cash flow that would have looked like a steal during the credit boom’s glory days.

Blackstone Group, after all, paid Cadbury-type multiples of revenue and operating cash flow for Freescale Semiconductor, a business—semiconductors, for goodness sake—that’s as cyclical, unstable and unpredictable as the chocolate company’s is non-cyclical, stable and predictable. Oh, and it’s a low-margin and highly capital-intensive business, to boot.

Nevertheless, Warren Buffett opposes the Kraft-for-Cadbury deal because, as he said during an early morning interview, in a typically Buffettian utterance, that as Kraft’s largest shareholder “I feel poorer.”

So let’s compare what Kraft is willing to pay for Cadbury with the price Warren Buffett is willing to pay—using both cash and a slug of shares of Berkshire Hathaway—for Burlington Northern, a “Class 1” American railroad that was assembled through mergers at the rate of one-per-decade starting in the 1970s.

Berkshire, which already owns 22% of Burlington (most of that purchased for close to $80 a share) is paying $100 a share for the rest of the company. All-in, that amounts to $34 billion for the equity plus about $9 billion in net debt, for a total price of roughly $43 billion, according to my Bloomberg.

Keep in mind, Burlington is a railroad, not a chocolate maker. While railroad operating margins in the good times can hit 23%, in the bad times they can get down to 15%, or less. Cash flows tend to be healthy, but so do capital expenditures.

Indeed, the Chief Financial Officer of CSX, one of the other three “Class 1” (it means “big”) railroads in the U.S., reflected on just that subject at an investor conference this week:

“Yes, we spend a lot of money. We always have. People are always for some reason I’m perplexed with [asking] why the industry spends between 15 and 17% of our revenue. It is a highly capital intensive business.”

For this cyclical, GDP-dependent railroad operator, Berkshire is paying almost 20-times trailing earnings, 9-times trailing cash operating income (EBITDA), and 2.7-times book value.

None of those numbers look like a steal.

Indeed, as Buffett himself has often pointed out, “book value” for a consumer brand business like Cadbury ought to be far more valuable than an industrial, for the simple reason that the cash generated by a consumer brand doesn’t need to be invested in capital expenditures simply to keep the lights on—as with a railroad.

All in all, Buffett’s Burlington investment, as he has been widely, and memorably, quoted, really does represent an “all-in wager on the economic future of the United States.”

As for using precious Berkshire stock in his deal, while at the same time criticizing Kraft for doing the same in their deal, Buffett’s answer here today is not so memorable:

“I’ve written the annual letter,” he says—Buffett drafts his unique, 20-page annual shareholder letter by hand; ace Fortune Magazine Editor and longtime Buffett confidant Carol Loomis edits it with, I am told, a very light touch—“and I deal with this.”

He continues with a line from his earlier CNBC interview: “Charlie and I like using stock for an acquisition about as much as we like preparing for a colonoscopy.” It’s a great line that generates laughs and will surely be the quote of the day, as Buffett surely knows.

“We are paying $100 a share [for Burlington]…but it costs us somewhat more than that because we are using stock on the low side of its historic range of book value, as a proxy for value.”

Buffett moves his hand up and down to indicate a theoretical price range, and keeps his hand down to reflect the lower end of that range: it is the first time in years he has publicly offered an observation on the current market value of Berkshire Hathaway stock.

“So when we looked at the Burlington deal we regarded it costing us somewhat more than $100 a share because we are using stock we would not like to issue.”

Having admitted to paying with undervalued stock, Buffett rationalizes the price in two ways:

“We already owned 22.5% of Burlington... We’re getting to use $22 billion of cash advantageously, and we will get to use more cash in that business, we think advantageously… So we thought the deal was okay.”

As to why use stock at all, Buffett says, without stating this out loud, that the deal wouldn’t have happened without some stock component to the price:

“If we had to use more [Berkshire] stock, I wouldn’t have done it. They TALKED about us using more stock, but I wouldn’t have done it.”

He then takes a parting shot at Kraft, with Charlie Munger’s input:

“I wish that Kraft, looking at THEIR deal, [had considered the value of the stock consideration]. I hope they considered that when they were making their calculations…”

Charlie Munger’s voice—Buffett has been sitting next to a cutout of his partner the entire meeting—breaks in, and breaks up the shareholders watching:

“I couldn’t agree more.”

In “Pilgrimage to Warren Buffett’s Omaha”—a hedge fund manager’s journey to the heart of Berkshire Hathaway—I noted that a remarkable number of German shareholders manage to line up first at the microphones in order to ask questions of Buffett and Munger during the Saturday question-and-answer session.

And today, the first international shareholder happens to be from—yes—Germany.

Specifically, from Hamburg, which is mainly famous as the port city where the Beatles developed their chops while playing to drunken sailors and other detritus of World War II.

And although this shareholder’s question has nothing to do with the Beatles, the second half of it does relate to Hamburg’s historic role in the Germany economy.

“What is the expected return on capital from Burlington? And if you can’t buy more railroads would you expand into shipping?”

Buffett responds, and the answer is both surprising and entirely expected.

To be continued…

Jeff Matthews
I Am Not Making This Up

Photographs and Content © 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Anonymous said...

JM, Thanks for posting on Buffett.

Do you see any new Buffetts on the horizon?

Has the Berk train left the station?

What do you think about Loews?

Love ya

Anonymous said...

Good stuff, Jeff.

My guess is shipping - no, but ports - yes.

Shipping has remarkably low barriers to entry. Ports, on the other hand, utilize large amounts of capex but have sufficient barriers to entry. Regrettably, aren't most ports govt-owned authorities that grant operating concessions for the port facilities.

But What do I Know? said...

Regarding using stock for acquisition, it sounds like Buffett is saying something on the order of "It's OK when I do it, but not when Kraft does it." That, my friend, is the definition of hypocrisy. I'm sure Mr. Buffett and his defenders can come up with all sorts of distinctions about why it's not in his case, but just add it to the long list: Buffett railing against nepotism on corporate boards, but placing his children on his; demanding transparent financial statements from others when his own is a one page masterpiece of opacity; descrying government interference even as he benefits from it, expounding on the dangers of derivatives while making a huge bet with S&P 500 puts, etc.

And, oh yeah, the one about the colonoscopy is so old and hackneyed it really isn't funny anymore.

Thanks for elucidating the sins of this double-talking, narcissistic phoney.

BobE said...

Some data corrections are in order.

The large railroads are Class 1, not Class A.

There are seven, not four, of them. CSX, Norfolk Southern, Burlington and Union Pacific are the large-cap US-based ones. Kansas City Southern, Canadian National and Canadian Pacific are also Class 1s, though the first is a mid-cap at $3 billion and the last two based in Canada but with significant US operations. The definition of a Class 1, versus Classes 2 or 3 is based on annual revenue generation, not market value or index membership.

Alain said...

The thing I take away from that question is that Buffet actually took into account that Berkshire stock was undervalued for the Burlington acquisition while it doesn’t sound like Kraft did. I am guessing that Buffet must have had discussion with Kraft management to come to that conclusion although he doesn’t come right out and say it.

BGM said...

Jeff -

What similarities and differences do you see between Buffett's General Foods investment from a couple of decades ago and his current one in Kraft?

Thanks for the input and I hope you enjoyed your visit to STL.

Jeff Matthews said...

BGM: St. Louis was terrific. Great crowd, great questions.

Kraft has the brand power General Foods had, but when Berkshire bought Kraft it wasn't the killer undervalued business General Foods was at the time Buffett accumulated GF.

Still, much of today's Kraft came out of yesterday's GF, since Phillip Morris had bought them both in the 1980s!

Thanks for coming.


Jeff Matthews said...

BGM: St. Louis was terrific. Great crowd, great questions.

Kraft has the brand power General Foods had, but when Berkshire bought Kraft it wasn't the killer undervalued business General Foods was at the time Buffett accumulated GF.

Still, much of today's Kraft came out of yesterday's GF, since Phillip Morris had bought them both in the 1980s!

Thanks for coming.